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Modeling of Interest Rate Term Structures under Collateralization and its Implications

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  • Masaaki Fujii

    (Graduate School of Economics, University of Tokyo)

  • Akihiko Takahashi

    (Faculty of Economics, University of Tokyo)

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    Abstract

    In recent years, we have observed dramatic increase of collateralization as an important credit risk mitigation tool in over the counter (OTC) market [6]. Combined with the significant and persistent widening of various basis spreads, such as Libor-OIS and cross currency basis, the practitioners have started to notice the importance of difference between the funding cost of contracts and Libors of the relevant currencies. In this article, we integrate the series of our recent works [1, 2, 4] and explain the consistent construction of term structures of interest rates in the presence of collateralization and all the relevant basis spreads, their no-arbitrage dynamics as well as their implications for derivative pricing and risk management. Particularly, we have shown the importance of the choice of collateral currency and embedded "cheapestto- deliver" (CTD) option in a collateral agreement.

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    File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2010/2010cf762.pdf
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    Bibliographic Info

    Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-762.

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    Length: 20pages
    Date of creation: Sep 2010
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    Handle: RePEc:tky:fseres:2010cf762

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    1. Michael Johannes & Suresh Sundaresan, 2007. "The Impact of Collateralization on Swap Rates," Journal of Finance, American Finance Association, vol. 62(1), pages 383-410, 02.
    2. Patrick Hagan & Graeme West, 2006. "Interpolation Methods for Curve Construction," Applied Mathematical Finance, Taylor & Francis Journals, vol. 13(2), pages 89-129.
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